By Boyce F. Lowery, CLU®, ChFC®
Congress has provided special tax treatment for retirement plans like an IRA or a 401(k) Plan to incentivize us to save for retirement. They know that if we don’t have our own savings to tap during our retirement years, we will be forced to turn to the government for aid, which can be costly to taxpayers. So the government does what it can to get us to save our own money. Not only do politicians want us to put money into our retirement accounts, they also want us to keep it there until our retirement years.
What is the 10% Penalty Tax?
To motivate us to keep our money set aside for our retirement years, the IRS penalizes withdrawals prior to age 59 ½. This Penalty Tax is in addition to the income taxes we will owe on the tax deferred funds. Withdrawals taken before age 59 ½ are called “early” or “premature” distributions. The penalty for taking such distributions is a 10% additional tax.
Most retirement account withdrawals are taxed at your marginal income tax rate for the tax year you made the withdrawal. The penalty for early withdrawals does not negate the regular income tax; it is added on top of it.
Exceptions to the Penalty Tax
There are certain circumstances in which you can take an early withdrawal and avoid the penalty. Those exceptions are as follows:
First-Time Home Purchase
Perhaps the most popular early withdrawal, you may be eligible to take up to $10,000 out of certain retirement accounts in order to purchase your first home. This is allowed with IRAs, SIMPLE IRAs, SEPs, and SARSEP plans. However, such withdrawals are not permitted from a 401(k) and other Qualified Plans.
As with first-time home purchases, funds from an IRA, SIMPLE IRA, SEP, or SARSEP plan can be used for higher education expenses without penalty. The withdrawals cannot exceed the qualified educational expenses for the tax year. Qualified Plans, however, do not allow such penalty-free withdrawals.
If you have unreimbursed medical expenses that exceed 10% of your AGI, you can withdraw the excess amount over 10% of your AGI from your retirement account without facing the 10% penalty. However, the withdrawal must be made in the same year the medical expenses occurred. Also, distributions from an IRA, SIMPLE IRA, SEP, or SARSEP plan can be taken penalty-free to pay for health insurance premiums while you are unemployed, once unemployed at least 12 weeks. Health insurance premium payments cannot, however, be taken from a 401(k) or other Qualified Retirement Plan.
If you have to withdraw money from your 401(k) or other qualified plan in order to rectify an excess contribution, excess aggregate contribution, or excess deferral, you do not have to pay the penalty. Because having the money in the account violates the rules for the plan, you can take it out without any negative consequences.
If your employer-sponsored plan is subject to automatic enrollment, you may withdraw the automatic contributions without owing the 10% penalty. In order to do so, you must make the withdrawal election within the time stated by the plan (30-90 days after the first automatic contribution is made).
The IRS has a special program for making penalty-free withdrawals called the Substantially Equal Periodic Payment (SEPP) program. The program lasts for 5 years or until you turn 59 ½, whichever is longer. You will receive annual distributions calculated by the IRS throughout the life of the program. The IRS has three different options for how to calculate the payments, and you get to choose which is most appropriate for your situation. While participating in the SEPP program, you cannot make contributions to or other withdrawals from your account. Terminating the SEPP early or violating the rules can result in owing the 10% penalty for all distributions taken during participation in the program.
Death & Disability
If you pass away, you obviously will not need the money for retirement, so it can be distributed to your beneficiaries or estate without penalty. Also, a total and permanent disability basically requires you to retire from work regardless of your age, so distributions are allowed penalty-free. Penalty-free does not mean tax free.
You are allowed to withdraw funds from an account penalty-free if you are putting them directly into another retirement account. You only have 60 days to get the funds into the new retirement plan or IRA. After the 60 days have passed, you will have to pay the 10% penalty even if you eventually put the money into another retirement account. Because of this, it is best to have the funds sent directly from one account to the other instead of personally receiving a check.
Separation from Service
If you leave your job after age 55, you are allowed to begin receiving distributions and won’t be required to pay the penalty.
If there is a Qualified Domestic Relations Order requiring payments be made to someone other than the account owner, those payments will not be subject to the 10% penalty.
Qualified military reservists called to active duty can take certain distributions penalty-free. They also have the opportunity to repay the distributions during the two-year period after their active duty ends.
Employee Stock Ownership Plan (ESOP)
Any dividends paid as a part of an employee stock ownership plan are not subject to the 10% penalty.
If there is an IRS levy on the plan, any related distributions are not penalized.
How to Claim the Exception
Sometimes, even if your distribution qualifies for one of the exceptions above, your IRA custodian tax reporting may not reflect that fact. When that happens, you have to file IRS
Form 5329. On that form, you will report your distributions and the amount that is eligible for the exception.
If you would like our assistance in helping you plan for your retirement years whether accumulating enough funds or planning how to best distribute those funds or you simply have questions, we at Suncrest Advisors would be happy to help. Call our office today at 888-827-0146.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the managing partner of Suncrest Advisors, he, his partner, and their associates all aim to provide financial security and peace of mind to business owners, executives and professionals, and high net worth individuals across the United States. Along with more than four decades of experience, Boyce is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit https://suncrestadvisors.com/ or connect with Boyce on LinkedIn.